Pension vs. ISA – the Saga continues

There is a huge amount of debate around when it comes to the Pension vs. ISA question. For me the answer is easy – both! The ISA debate is more complicated now that there is the LISA, Help to Buy ISA, and god only knows what others coming (and ISAs were supposed to be simple?!), but there are pro’s and con’s to each. I know this has been done to death all over the FI community and in the papers, but I thought I would add my take on it, so feel free to skip if you are bored of this!

It seems clear that the government is continuing to push people away from using pensions, mainly to target increasing their tax take now, rather than in the future (in my opinion). This to me seems very short sighted as it discourages people from saving for retirement and forcing people to lock their money away and not fritter it away when the feeling takes them.

I also like the idea of in effect deferring my tax (I pay too much IMO, but then I suspect everyone thinks that!). I will pay tax on it at some point when I start to withdraw it from the wrapper, but given the new freedoms I can see that I should be able to minimise the tax, which maybe why they are after it now. How much I can avoid paying tax on I don’t know, but I expect I will still take a tax hit in some way.

In the UK, especially if you are after FIRE, then you may also want to consider other options of investing, however for a couple you have two lots of £40,000 in the form of pension contributions (assuming of course you don’t earn too much), and now two lots of £20,000 post tax income that you can shelter in tax efficient manners. If there is still money left after that, then you can look at Buy to Let (although this is becoming less efficient investing with the tax changes), pay down your mortgage (assuming of course you still have one), or invest in a non tax sheltered account (not that attractive with the tax implications on dividends but a way to take advantage of Capital Gains Tax). There are lots of ways to keep your tax bill to a minimum.

For the sake of this post I am only looking at the Pension vs. ISA side, if you are able to fill both of these, and more, then fair play 🙂 Further, I am only considering Defined Contribution pensions, rather than the rare unicorn that is Defined Benefit.

Pensions

Most people put the minimum amount they can in, to the default fund, forget about it and don’t look at it until they are almost ready to retire and then wonder why they aren’t even going to be able to afford Aldi own label bread. To me this is a problem with the financial education, people should take the interest, even if it is only tracking to see that they are not having their savings eaten alive by fund charges. With the death of gold plated Final Salary schemes these days it is even more important – the onus is on the individual to make sure they can save enough.

When you start out working in your 20’s, knowing that you can’t access the money for over 30 years seems a tough one – I certainly never had any doubt that I would be alright, but that was some form of self belief and confidence that I had when I was young! If you are wanting to stop working at 40, tying up your money until you are 55 (or maybe even longer depending on government changes), this may not seem sensible.

For what it’s worth – when I first started working I would have been able to access my pension at 50, not so now. Had they not changed these rules than I would definitely be able to retire at 50, now it is a bit more tricky.

Pro’s

  • Tax relief. I don’t think this can be underestimated – whilst not massively beneficial to a 20% tax payer, to a 40% or 45% (subject to allowance) this is a huge perk. I put in my (highly) taxed money, it automatically gets ramped up by the basic tax relief, then I complete my self assessment form and either have a higher tax free level / monthly income for it, or I get a nice little bonus once a year with the refund. If you are in the 40% (or 45%) bracket, I think it’s madness not to put money into your pension and get as low down the tax bracket as possible, accepting the restrictions this may have
  • Handling your income band. This has the advantage of keeping you tucked under a specific banding, be it 40% tax, 45% tax rates, child benefit reductions, the £100k 60% trap or so forth. Nothing else can help like the pension can here and can have a material change on your take home pay as well
  • Safe from any bankruptcy issues. Whilst I would guess the probability of someone who is interested in getting to FI is much lower than average, you never know what the future holds. If you are declared bankrupt or hit issues, people can come after your regular savings and ISAs to help settle bills, whereas your pension is safely tucked away and can continue to grow
  • A fairly hefty contribution allowance (unless earning over £150k) of £40,000 per year means you can keep a large amount of wealth outside of the taxman until retirement – provided you earn that much of course
  • Tax free lump sum available (I need to look into more to see how best this can be utilised from a tax planning perspective). So not only do you get to put in money, tax free. It also grows, tax free. You can then withdraw 25% of the pension, tax free! This is an incredible perk (how long it will last is another matter) – in effect I am expecting to be able to take out nearly all of my contributions (cash equivalent) when I can access my pension, meaning that everything else in the pension is grown capital. How cool is that?!
  • Employer contributions. By law, employers have to provide a work place pension now, and also contribute to it. No matter how small, even 1% extra helps, so it is further free money that you wont get if you don’t join it, so sign up, take an interest, and invest!

Con’s

  • You can’t access it until 55+, a real drag for a lot of people who are looking for FIRE. Knowing that you may have 5, 10 or maybe even more years before you can get at the money after your targeted FIRE date means you may end up delaying your freedom date because you can’t access the bulk of your funds
  • The Lifetime Allowance (LTA). Whilst this seems nonsensical to me, it is what it is. I would hope over time, as the annual allowance keeps getting cut, that they will drop the stupid LTA. In effect if you get stellar returns from some of your investments (Russian gold miner anyone?!) then through no fault of your own you will get penalised. For me I can really see myself ending up moving money into cash rather than invested so I don’t get penalised. This is insane – why not let me accumulate more as in all likelihood my spending will then go up, so not only will HMRC get more money from direct taxation, but also from VAT, restaurant employees etc. as I spend my hard earned cash
  • Constant Government meddling. Although this budget (March ’17) is one of the first in recent years that has not had a change to the pensions scheme, Mr. Osborne and Mr. Brown have been constantly meddling (ruining!) pensions in their time, and it is highly likely that this will continue in the future. I do have an issue with the government saying it is “losing” money on the tax subsidy for the rich, but in fact the reason the rich get so much back is because they pay so much in tax in the first place. If they do change the tax relief approach, then people risk getting double taxed, so taxed on the way in (similar to an ISA but probably at a slightly lower rate), and taxed on the way out. Talk about discouraging savings!
  • Withdrawals are taxed at the relevant and prevailing tax rates. We have no control over what the future tax rate would be – it could come down (I can dream, right?), it could go up. Tax allowances may change. It is a huge unknown, but at least with the pensions freedom we now have the ability to change how much we withdraw to ensure we minimise the tax hit

 

ISAs

So I really do believe that everyone should have an ISA (I am thinking particularly Stocks and Shares not cash) – the only reason to have a cash ISA at the minute for me is if you can’t afford to fill your S&S ISA and need to keep cash. I am not going to go into the details of an Innovative Finance ISA or Lifetime ISA etc. for the sake of simplicity I am only looking at a standard S&S ISA.

The government seems to be smiling on ISAs with the allowance going shooting up over the years to £20,000 per person per year from the ’17-’18 tax year. This is a huge amount of cash to find for the majority of people to find. If you are a city banker, or a high flyer somewhere then it is easier, but £20k of taxed income is a large amount of cash regardless.

I do believe that this is part of the governments attempt to kill off pensions – they get the tax take up front then and can spend it as they see fit (badly in other words!). My concern is how long it will be before we get limits on how much can go into an ISA or how much can be saved there. Whilst Lord Lee became the first person to be an ISA millionaire, nowadays it is becoming theoretically easier and easier to get there (I say this based on the limit, not on the ability to put that much in!).

I am not an ISA millionaire yet sadly, and I am a some way from it, however I would love to get there so the more money I can put into an ISA the better IMO. If I can hit a million in various ISAs when I come to retire then I will be very happy.

Pro’s

  • Currently unlimited tax free growth – you put money in that’s it. If you get stellar returns and end up with millions in there, great. No capital gains tax, no need to fill in a tax return for it, just keep going. Any dividends can be reinvested without any tax implications as well
  • Withdrawals are tax free, regardless of how much you pull out, and when. Suppose you were an ISA millionaire and you decided to cash the lot in, sell everything and withdraw the lot. £1,000,000 into your current account. The tax bill? £0. This gives the potential for almost unlimited upside. This is just fantastic, and considering you could contribute all your life (from Junior ISA on), even if you only start at 18 or 21 in your first job, slow and steady does the job
  • Currently only positive government meddling (I.e. increasing the limit). It seems that the government is very keen to promote ISAs (at the cost of pensions IMO), although they are starting to make it more and more complicated with FI ISA, LISA, Help to Buy ISA etc. But so far no cuts in what can go in or the growth, now is the time to make the most of it!
  • A pretty reasonable allowance, especially when a couple combine. Whilst not as high currently as the pension contributions the new £20,000 is a large whack of post taxed cash to find – with tax free allowance etc. You would need to earn about £25,000 per year to just fund the ISA alone – that’s assuming your monthly living cost is £0!

Con’s

  • Can be easily accessed, so temptation is always there to dip in. There are no penalties to decide you really need that latest holiday to Ibiza / Walking in Wales / Helping Orphans in Peru (whatever tickles the fancy) which means if things get too much you can harm your long term savings
  • Counts as part of means testing for some benefits. This is a savings vehicle after all, so will count as part of your assets, so for example if you are unemployed, run out of emergency funds, the government will expect you to sell down your ISA before it will give you support
  • Included in your estate should you need to enter debt negotiations (highly unlikely in the FIRE community). No company is going to accept reduced repayment on debt when they can see you have savings, they are going to demand you sell up and repay the debt

So for me, there really isn’t a clear winner between the two, but the importance of the vehicle does vary according to individual circumstances.

When a pension beats an ISA

There are some occasions when it is clear that you should invest in a pension over an ISA. Remember of course that this is my personal view, you need to make your own mind up 🙂

  1. When your employer will match your contributions. You should never turn this down – it is free money. If they match you to 5%, you should put 5% in, as this would give an immediate 100% return. When you are hitting the LTA or over the allowance, then its time to think hard, but I would suspect even with a 55% tax charge you may still be better off taking the hit (I would need to work through the numbers)
  2. When you are around the limit of a Tax or Benefit band. For example if putting an extra £1,000 into a SIPP to avoid paying the 40% tax would be a benefit – after all would you rather have ~£550 in your take home pay (don’t forget the NI charges), or £1,000 in your SIPP?
  3. If you struggle to resist temptation and can’t build up a good pot of retirement funds then the enforced lack of access of a pension will remove this temptation

When an ISA beats a pension

Equally there are times when an ISA would beat a pension

  1. When you need funds in the relative near future (i.e. before 55/57/whatever age the government changes it to) – ease of access being vital
  2. If all your other investments are in pensions – you want some ready investments especially if FIRE is in your sights
  3. When you are at risk of hitting the Life Time Allowance (LTA) in your pensions. £1,000,000 sounds like a scarily big number. Suppose, for ease, your salary is £24,000 and you get a 5% match from your employer, that gives you £200 per month to put in. Do that for 35 years, at 7% return and you will hit £360,000. Make it 45 years and its over £750k! That assumes no pay rises, bonuses, side hustles etc. – not likely if you are thinking about FIRE so this is a real concern
  4. When you have a specific goal in mind, e.g. a wedding or childrens school / university fees and will need the cash

Conclusion

You will notice that I haven’t mentioned Inheritance Tax on this comparison, as this depends on the marriage (or not) and children (or not) situation of each individual, and these will of course change over time.

Despite all of the above, I still don’t believe there is any right answer to this, as it  is down to individual circumstances. For me, it has to be both. I put into my company pension, my personal pension, my ISA and my other half’s ISA. This means I have a spread of companies providing the tax efficient wrappers, and in both our names should the worst happen to me.

In an ideal world, I would like to be able to max out my pension contributions and fill both my and my other half’s ISA. That’s a heck of a lot of money to find but provides a great incentive to really try and maximise my savings. What would I do if I had money left over after that? Pay down the mortgage as much as possible. I will worry about that if I get to that stage!

What do you use – ISA or Pension, or Both? Or do you say to hell with this savings lark, I am going on a luxury world cruise? 🙂

T minus 8 years and counting….

So on one of my early posts, Mike from 7 Circles asked me how far I was and what my number was to get to FI. Well with 8 years to my declared target date, this seems like the perfect time to answer that. For the purpose of my retirement numbers, I don’t include my home equity as I need somewhere to live! This number is purely based on pension and ISA savings (note: Excluding emergency cash).

So I do have a number in mind (which I am afraid I am not sharing), and right now I am about a third of the way towards it when you count pensions and ISAs. If I discount my pension then I am only 13% of the way there. I know I can’t hit my number with the ISA, even with maximum contributions to both my and my other half’s ISA, unless I get some truly stellar returns from some of my self select purchases. At some point I will have to work out how to address that, but that’s for the future.

Provided I get an average of 7% returns per year then I should hit the number pretty much to the month if things continue as is – something I wouldn’t have believed a year ago. I actually forecast my returns at 4% as part of the mental games with myself – if it looks like I won’t make it I will keep trying harder, and I also withdraw cash from my other half’s ISA to pay down the mortgage (income not capital). Anything above that is a real bonus. The challenge then is that quite a large chunk of this will be in my pension which I won’t be able to access at my chosen date. That gives me (currently) a 5 year gap.

I honestly have no idea right now how I will make that work (cash, selling down ISAs, unexpected extra cash from pay rises and bonuses in taxable brokerage accounts etc.). For now I just need to keep throwing money into my investments.

The other element I have in my back pocket is any bonuses I may get at work. Last year was a good year and my bonus went straight into my pension (tax refund still to come through although I finally got my P11D so I have submitted my tax return but I won’t get as big a refund as I had hoped). The same will happen with any bonus I get for this year – as always I assume nothing, but if I have a good year it could help to bring me closer to that magic freedom! This also assumes no increase in savings, which is hopefully not realistic – any pay rise I do get should go into savings. If I am lucky and get similar bonuses for the next 8 years then I really will be able to hammer those savings and mortgage overpayments.

One of the things I have started looking at more closely is my progress in my ISAs and how they are tracking against my original base forecast as I don’t want to have to sell down my ISA to survive through to my pension, so I am really pushing to get my ISA as high as possible. The more I can get into ISAs the better, and with two allowances (mine and the other half’s) that is a lot of money I can put to work. I am behind my original forecast and most months that difference keeps extending. Another target I can fail 🙂

How will I retire? Well I have a whole series of posts to come on that about options and so forth but the short answer is right now, I don’t know. Yup, you read that right, I don’t have a clue how I will make it work. I am not going to let that stop me saving as hard as possible. The biggest blocker to me retiring is the mortgage. It is by far my biggest expense, and has a long time to go on it. Realistically I don’t believe I will be able to clear it by 2025 which means I will still have some outgoings for housing when I retire.

Now I know that I am writing this after a long steady increase in stocks and my portfolios so of course it looks good. As it stands I do feel positive about it, I don’t think I will hit it, but I think it will be close. How will I feel after a major market crash? Most likely highly depressed and thinking it will be impossible to make it. That said, I won’t change my regular investments so I will buy more shares, cheaply, but it won’t be easy.

I know I will really enjoy looking back on this post over the years as I see how it progresses against my base expectations!

How are you getting on towards your target retirement date? Have you got it all perfectly mapped out, or only as far as “I need to save”?